For me it's very tough to be disappointed in any way with the market's performance in the first quarter. I have been pleasantly surprised at how well stocks have acted throughout 2006 thus far. The S&P 500 index rose by 3.7% for the period, even as 10-year bond yields jumped substantially, from 4.40% to 4.85%.
It was an excellent backdrop for stock pickers, and the performance of my 2006 Select List echoes those sentiments. The 10 stock list has posted a gain of 12.2% since the beginning of the year. The group was led by 4 stocks that jumped more than 30% each, including Lionsgate (LGF), the movie studio behind Crash, the Oscar winner for Best Picture.
Heading into the second quarter, my outlook remains as it was on January 1st, cautiously optimistic. I still think we are set for mid-to-high single digit returns on the S&P 500 in 2006. Earnings should continue to be strong, but without multiple expansion, huge gains in the indexes are unlikely. Low double digit gains are not out of the question, but we would need many things to fall into place, including a Fed that stops raising rates soon and oil prices that are subdued. Possible, but not probable in my view.
Given that we got nearly a 4% gain in Q1, I can't help but think we are overdue for a market correction. We haven't seen a 10 percent drop in more than 3 years, which is very unusual. Market momentum is very strong here and first quarter earnings reports this month will likely be solid, but as we enter a seasonally weaker period for stocks, I am still expecting a pullback even if it doesn't seem like the market wants to go down right now.
That said, there are still many individual stocks that are attractive. As share prices have rallied the list of undervalued names has undoubtedly gotten smaller, but values can still be found by those who look hard enough. And I would suggest holding some cash because when a correction comes, the list of bargains will once again expand.
Best of luck to all of you in the second quarter.
Shareholders Sue No Matter What
From the Chicago Sun-Times:
Judge OKs lawsuit by those who lost money during Kmart takeover
A federal judge in Chicago has given the green light to plaintiffs who charge that Sears Chairman Edward S. Lampert and former Sears CEO Alan Lacy failed to tell shareholders they were plotting Kmart's takeover of Sears Roebuck and Co.
The plaintiffs making the complaint sold their Sears stock between Sept. 19 and Nov. 16, 2004, and lost out on a spike in Sears' share price that occurred when Kmart and Sears announced Nov. 17, 2004, that Kmart would acquire Sears.
U.S. District Judge Robert W. Gettleman ruled that the aggrieved shareholders cited sufficient facts so they can try to prove that Lampert and Lacy violated securities laws by failing to fully disclose their negotiations.
The shareholders allege that Sears, with Lacy's knowledge, was repurchasing shares at what they contend was an artificially low price, effectively increasing the interest of Lampert's hedge fund and making Kmart's takeover of Sears easier.
Now not only do we have shareholders who sue when stocks they own take a tumble, we also have those who sue when stocks go up after they sell? Lawsuits in this country are really getting out of hand. Let's go through a few reasons why this story is ridiculous.
First of all, the headline doesn't even make sense. You can't "lose money" on a stock you no longer own. Missing out on profits and losing money are not the same thing. If you thought about buying a Powerball ticket when the jackpot hit $200 million but decided not to, you didn't lose out on a chance to win the lottery. You simply chose not to play.
The basis of the lawsuit is that Kmart management failed to disclose they were in merger negotiations. What company in their right mind would disclose this? As soon as news of such talks hit, Sears stock would have rallied, raising the price Kmart would need to pay. This would hurt Kmart shareholders, not help them, making the deal less attractive financially. Arguing somebody broke securities law by not disclosing buyout negotiations, which could easily have broken down, is preposterous.
They go on to say that Sears was repurchasing stock at low levels to make Kmart's takeover easier. There would be no reason for Sears to do this, it would not have a meaningful effect. Sears stock was cheap. That explains why Sears was buying back shares and why Kmart was interested in a business combination. That is just a good use of capital by both sides. Shareholders of both Sears and Kmart should be happy about that. In fact, the reason the stocks soared once news of the merger broke was because it was perceived as such a good move. Both retailers were struggling and this was seen as a way to get smaller, leaner, and more profitable.
Current Sears Holdings shareholders need not be worried. This Chicago Sun-Times article is the second I've read in recent days that sharply criticizes and questions the current retailing strategy of Edward Lampert and company. As long as people are still negative and focused on retail strategy and not economic value, I'm happy to be a shareholder of Sears Holdings.
Lagging Fidelity Fund Seeks to Change Benchmark
In the latest example of how mutual fund companies couldn't care less about their long suffering shareholders, consider Fidelity's recent announcement that it will be recommending its Blue Chip Growth Fund (FBGRX) change its benchmark from the S&P 500 index to the Russell 1000 Growth index.
As soon as I read about the proposal I knew a little research would yield some interesting findings. Sure enough, the Fidelity Blue Chip Growth fund has trailed the S&P 500 for six straight years.
In the real world such pitiful performance would result in the manager of the fund getting fired. But who are we kidding? The mutual fund world is nothing like the real world. Fund managers hardly ever get canned, even though 80 percent of them fail to beat their benchmark. So what does Fidelity decide is the proper course of action? Well of course, change the benchmark!
You guessed it, the Russell 1000 Growth index has lagged the S&P 500 over the last five years, so the switch will make it look like Fidelity Blue Chip Growth has done better than it actually has. Interestingly, the fund has also lagged the Russell 1000 Growth index over the last five years, just not by as wide a margin as it has the S&P 500.
Alright, so maybe you're thinking I'm being a little too cynical here. Maybe the Russell 1000 Growth index really is a better benchmark for this particular fund, based on the companies it invests in, and therefore such a change can be adequately defended. I admitted that was a possibility, so I did a little more digging. If Fidelity Blue Chip Growth is really quite different from the S&P 500 index, I'll be happy to get off their backs.
The top five largest holdings of the Fidelity fund are Microsoft, GE, Johnson & Johnson, AIG, and Intel. Sounds like the S&P 500 to me. What did I find when I peaked at the Vanguard Index 500 fund (VFINX), the largest S&P 500 index fund in the country? GE is the fund's 2nd largest holding, followed by Microsoft at #3, Johnson & Johnson at #5, AIG at #8, and Intel at #10.
Let me throw one more statistic out there that I find too amazing to ignore. In case it was just the largest holdings of Fidelity Blue Chip Growth that overlapped almost exactly with the S&P 500, I decided to look at the market cap of the fund's average holding versus the average market cap of the S&P 500 index fund. Guess what? They're exactly the same... $46.9 billion versus $47.1 billion!
And yet Fidelity is trying to get away with saying they think the S&P 500 isn't a good benchmark for the fund? Investors should not tolerate this. Unfortunately though, most of them probably have no idea it's even going on. Fortunately, that's one of the purposes of this blog.
Buffett Record is One Thing, Outlook Quite Another
Before you go out and buy a stock simply because Warren Buffett either has owned it for a long time or recently purchased it, consider the following quote from his letter to shareholders, released yesterday."
Expect no miracles from our equity portfolio. Though we own major interests of a number of strong, highly-profitable businesses, they are not selling at anything like bargain prices. As a group, they may double in value in ten years. The likelihood is that their per-share earnings, in aggregate, will grow 6-8% per year over the decade and that their stock prices will more or less match that growth."
What should investors gleam from this statement? Should they take it at face value, or just assume Buffett is being modest and trying to keep expectations low so he can exceed them more easily? If you are one of the many people who have asked me about my views on some of his larger holdings in recent months, you already know where I stand on this issue. Take what Buffett says as the truth. His days of drastic outperformance are long over.
Consider Berkshire Hathaway's performance in 2005; up 6 percent using the metric Buffett prefers. That compares with 5% for the S&P 500 with dividends reinvested. A solid year, but hardly something that one should bend over backwards to mimic. It also is right around the 7% estimated growth rate he offered in his letter.
Consider Berkshire's largest holding as of December 31st; more than $8 billion dollars of Coca Cola (KO). Coke stock has been dead money for 10 years, even as the S&P 500 has nearly doubled, as the chart below shows.
I will repeat here what I have told those who have asked. I would not expect shares of Berkshire, or Coca Cola, or Anheuser-Busch, or Wal-Mart, or Proctor & Gamble, or Washington Post, or any of Buffet's other large holdings to make you rich from here on out. They were all great buys at some point in time, say 15 or 20 years ago, but now they are richly priced, even as growth prospects have diminished greatly as they have grown into industry behemoths.
Why then does Buffett continue to hold these stocks, even if he only expects them to return 7% per year? The answer lies in the fact that he has said his ideal holding period for a stock is "forever." If I was to argue with Buffett on one aspect of his investment philosophy, that would most likely be the one I would choose. Holding a stock "forever" will ensure you own it during both the good times and the bad times. The latter is something investors should strive to avoid.
Analyst Costs Sherwin Williams Investors
If you read this blog regularly you know that I don't listen to sell side research analysts. Upon hearing this I often get strange looks from prospective clients until I explain why. It's pretty straight forward actually; analyst stock picks won't make you any more money than a monkey will throwing darts at the Wall Street Journal stock tables.
Today's example comes to us from Eric Bosshard, the FTN Midwest research analyst who covers Sherwin Williams (SHW). Collectively, Wall Street analysts were fairly bullish on Sherwin Williams coming into February. Of 9 analysts who follow the company there were 6 buy ratings, 3 holds, and no sells. Shares of SHW closed February 1st at $54 per share.
Last week, SHW and other paint makers lost a lawsuit claiming public nuisance for selling lead paint in Rhode Island in the 1970's. Shares of SHW tumbled to as low as $37.40 last Thursday, before rebounding to close at $45.55 yesterday. As the stock fell from $54 to $37, nobody upgraded the stock to "buy". Now we can say the lawsuit uncertainty prevented them from recommending the stock, but very few people could make the case that a public nuisance verdict against SHW should cost the company 31% of its market value in a single day.
There was one analyst who changed his rating. Eric Bosshard of FTN Midwest pulled his "buy" rating on Thursday morning. As you can see from the chart below, his call marked the bottom, and it quickly rebounded more than 20 percent in a matter of days. I don't want to even think about how many people sold Thursday morning after his call.
This type of story plays out all too often on Wall Street. What's worse is what will likely happen from here. Afraid of looking like an idiot, Bosshard will probably keep his "hold" rating, hoping for further downside that will vindicate his call. The stock will continue to rise and eventually get all the way back to its old highs. With the problems in the past, he'll recommend the stock citing "diminished uncertainty surrounding the Rhode Island verdict". FTN Midwest clients will have bought high and sold low.
Perhaps what's most striking about this story is the fact that on the very day that FTN downgraded the stock, Sherwin Williams insiders, including Chairman and CEO Christopher Connor, were buying shares in the open market. Pretty ironic if you ask me.
Why Large Caps Are Lagging
For years large cap stocks have been trounced by small and mid cap stocks. Coming into 2006, most experts were predicting a move toward large cap outperformance. So far though that has yet to come to pass. In fact, the Russell 2000 small cap index gained 10 percent at the outset of the year, about triple the gain of the S&P 500.
Now it is true that historically larger companies do not advance as much as smaller companies. Small caps do best, followed by mid caps, with large caps bringing up the rear. This trend though has been even stronger than normal in recent years. Why is this true, and will it continue?
Stock prices in general are richly valued today, based on price-earnings ratios. As a result, stock price appreciation has not come from multiple expansion this decade, as it did in the 1990's. Rather, earnings growth has been the only way to see outsized share price gains as multiples have either remained the same or contracted.
Common sense tells us that small and mid cap stocks will have an easier time growing earnings. After all, they are growing off a much smaller base of business. A $100 million company need only add an incremental $10 million in business to grow 10%, but Wal-Mart needs to add tens of billions of dollars in sales to reach the same level of growth.
Will small caps and mid caps continue to outperform? Over the long term, absolutely. However, the gap in performance may not be maintained at the levels seen in recent years. As you can see from the charts below, small and mid cap stocks are soaring, hitting new all-time highs
S&P Mid Cap Index (MDY) vs S&P 500 - 10 Years
Mid cap stocks have doubled the returns of large caps over the last decade.
Russell 2000 Small Cap Index vs S&P 500 - 3 Years
Small cap stocks have also outpaced large caps by a factor of two..
Equal Weighted S&P 500 vs Market Cap Weighted S&P 500
Even the smaller stocks within the S&P 500 index have outperformed the mega caps that dominate the index.
Rising Commissions? Since When?
I had to double check to make sure what I heard over the weekend was correct. A.G. Edwards (AGE), a St. Louis based firm with 7,000 brokers nationwide, is planning to raise their commissions by 5 percent beginning on March 15th. In addition, their postage and handling fee is jumping 10 percent to $5.50 per transaction. Yes, that is correct. The company will charge customers $5.50 to mail them each trade confirmation. BrownCo actually only charges $5 to make a trade, so you can see how out of whack these fees really are.
Amazingly, full service brokers continue to thrive, even when they are ripping off millions of investors. AG Edwards stands to bring in an estimated $50 million in incremental revenue from the price hike, as they generate $1 billion per year in commissions (40 percent of total sales). Now I understand investors take comfort in having a personal broker with whom to work with, but at what point does one think twice about paying these astronomical fees? After all, it costs next to nothing to execute trade, which is why discounters can charge less than $10 and still make a lot of money.
The statistics have shown that analysts aren't good stock pickers (sell-side research generates the investment ideas brokers in turn recommend to their clients) and the majority of mutual funds lag the market, so the buy side isn't that great either. Meanwhile, discount brokers now offer all kinds of stock research reports, the same research high-priced brokers are using.
Why then are investors content to pay a 2 percent commission to full service brokers? Think about it this way. Let's say you hold your average stock for a year. If you are paying 2% when you buy it and another 2% when you sell it, you're 4% behind the market's return assuming your stock picks are average performers.
With valuations where they are today in the U.S. stock market, the S&P 500 is likely to only average a mid-to-high single digit annual return for the rest of the decade at least. So, a full service brokerage customer is going to make about 4% per year net of commissions if the market returns 8% per year. Mutual funds will return about 7% in such a scenario, but transaction fees and loads could take that number even lower. No wonder index funds have become so popular. Compared with actively managed mutual funds and full service brokers, they are often a better option.
This current state of the investment advisory industry is exactly why I started Peridot Capital Management. The average mutual fund investor is going to underperform. The average stock broker is going to underperform. Investors who pick their own stocks often buy what they know and like, paying no attention to valuation. In doing so, they buy overpriced blue chips stocks that have done wonderfully over the last twenty years, and as a result, are set to underperform.
Unless you can earn above-average returns on your own, index funds are the best option of the four most common investment options, but by definition you can not outperform by owning them.
The answer, at least in my eyes, is pretty simple; investing with superior independent research from a personal investment manager, who is not working on commission, through an online discount brokerage account. Hence Peridot Capital was born.
Is Merrill Lynch Serious?
Merrill Lynch (MER) is changing the name of its mutual fund group to Princeton Portfolio Research and Management later this year. Now this might seem strange on the surface, just because as far as name recognition and brand awareness go, I would think investors would choose to invest with Merrill over Princeton. Maybe that's just me.
The part of this story that really got a laugh out of me was Merrill Lynch's reasoning for making the change. In essence they think a new brand will make it easier for them to gain market share in the retail mutual fund business. Their concern is that brokers and financial advisors with other major firms have avoided offering Merrill Lynch funds because they see it as giving business to their competition.
That seems like a very valid concern. I can't see many Morgan Stanley and Goldman Sachs brokers trying to sell Merrill funds to their clients. But isn't it hilarious that they think changing the name will help this problem? Do they think retail brokers are just going to start blindly recommending this new fund family without looking into them at all?
So they'll do a little research to find out exactly who these "Princeton" folks are, and they'll learn, if they haven't heard already, that it's the old Merrill Lynch fund family. And we're back to square one.
Side notes:
Amazon (AMZN) is getting hit by $4 today after earnings. As much as I like Legg Mason's Bill Miller, I really don't know what he likes about this stock. All I see is a perennial 40+ forward P/E, decent but not overly impressive sales growth, and very low margins (not much better than Borders and Barnes and Noble as was once predicted).
OccuLogix (RHEO) is down more than $9 in the pre-market, to $3 per share. The only reason I even know about this company is because I recall Cramer pumping it on his Mad Money show. Evidently their product showed no difference versus placebo. How he can suggest to average investors that they buy something this speculative on national television is beyond me. Maybe a 75% haircut in a single day will help viewers understand what he is doing. I still have not exactly figured out his motivation (and/or conflicts of interest) in pumping the small caps he does, but I suspect the answer is not comforting.
Legg Mason's Miller Understands the Game
Bill Miller, manager of Legg Mason Value Trust (LMVTX), has done something that no other fund manager can claim. Since taking over sole management of the fund, he has beaten the market each and every year, for 15 straight years. Is he just lucky like some efficient market supporters would claim? Or does he know something that others don't?
The answer is neither. Markets are not completely efficient. All they do is incorporate the consensus view of investors and use that to arrive at a prevailing market price. The conventional wisdom is collected in an efficient manner, but such wisdom is wrong more than it is right. Every quarter when public companies report their earnings, about 70 percent will either miss or exceed the consensus estimate.
Miller's most recent letter to shareholders outlines his strategy. His ideas will seem reasonable, logical, perhaps even obvious to many. However, when we look across Wall Street we see very few who put them into practice. Which begs the question, why?
People ask me all the time what my philosophy is, my approach to investing. These are the concepts investors must grasp to be good at what they do, before you even begin to look at an industry or a specific company's stock. Many individual investors choose to buy what they know, what they like. Many financial advisers at your big name retail brokerages recommend them as well. That can end very badly, for many of the reasons expressed below. These are excerpts from the letter.
"Unfortunately, when we purchase companies we believe are mispriced, it is often difficult to determine when the market will agree with us and close the discount to intrinsic value. Our goal is to construct portfolios that have the potential to outperform the market over an investment time horizon of 3-5 years without assuming undue risk. If we achieve that goal, we believe we will be doing our job, whether we beat the market each and every year or not."
"The most common error in investing is confusing business fundamentals with investment merit. A company that is doing terrifically well, that has great management and returns on capital, and great products and prospects, may be a terrible investment if the expecations embedded in the current valaution are in excess of those fundamentals. A company with poor business fundamentals, a mediocore management, and indifferent prospects may be a great investment if the market is even more pessimistic about the business than is warranted. The most important question in investing is what is discounted, or put slightly differently, what are the expectations embedded in the valuation?"
"Systematic outperformance requires variant perception: one must believe something different from what the market believes, and one must be right. This usually involves weighting publically available information differently from the market, either as to its magnitude or its duration. More simply, the market is either wrong about how important something is, or wrong about when that something occurs, or both."
Ford Axes Quarterly and Annual Guidance
Investors will likely view Ford's decision today to refrain from offering future financial guidance as a negative. After all, it could very well indicate that the company either has no idea how their financials will look, or that they have little confidence in meeting the objectives they will set.
Even if true, companies should join Ford and realize that it's too difficult and unproductive to accurately predict future profits, especially if you are managing a business for long-term success, not to simply meet investors' short-term goals.
Wall Street might not like it, but now Ford could be better able to make the right decisions to get back on track. This is not an endorsement of the stock, as I have not looked closely at it, just a pat on the back for getting rid of guidance that benefits nobody except the research analysts who rely on it to do the bulk of their jobs.